The Power of Leverage In Real Estate

There are a couple of schools of thought on the use of leverage (a.k.a. debt) for investing. Dave Ramsey preaches that everyone should be completely debt free and you should never use debt to acquire investments. Unfortunately that means that most of us would never have a chance to invest in real estate. I on the other hand believe that the responsible use of leverage can provide returns far superior to investments relying on cash only and dramatically accelerate the growth of your net worth while allowing you to reach goals you may have never reached otherwise. The use of leverage is one major advantage real estate investments have over others like stocks and bonds.

The Basics

The fundamental idea of using debt to invest in real estate is quite simple. You pay a portion of the purchase price for a piece of real estate with money from your savings and obtain a loan for the remainder. Although the concept is simple and the majority of people who purchase a home use this approach its true power is displayed when investing in rental properties. There are many forms of leverage and various strategies but in this post I will focus on the simplest one and the one that has provided me with great results.

Accelerated ROI

To illustrate Accelerated ROI from the use of leverage I’m going to provide two examples from my personal portfolio.

1) Almost 3 years ago I purchased a newly renovated rental property in an area that, based on research and regular monitoring, I felt was up and coming and therefore going to appreciate faster than average. I purchased the house for $155,000. I put 20% down ($31k) and obtained a mortgage for the remainder. Since this house had a lot of interested buyers I offered $5,000 over the asking price to give myself the best chance of wining the bid. Because I only put down 20% that extra $5,000 only cost me $1,000 out of my pocket. You’ll see how little that ended up making a difference. I then rented the house for a pretty nice cash flow but to keep things simple let’s assume I broke even on a monthly basis. Meaning the rent I collected equalled my total expenses (including my mortgage).

Today that house is worth about $325,000, which is a 110% return. That’s a really good return right? Wait, it get’s better. Remember I only put down $31,000. So my investment was only $31,000 but my return was $170,000. So my total ROI (Return On Investment) was a staggering 548%. Of course I’m excluding the closing costs to acquire the house and commissions when I sell but still! Where else can you get a 548% return on an investment with relatively little risk?

2) I know the cynics out there are probably thinking, “Ok, but he got really lucky that it appreciated so much”. Although identifying areas that are going to pop requires a lot of work and skill I can’t guarantee that level of price appreciation over such a small time period. So let’s look at another example that has not experienced such a dramatic price jump.

A little over a year ago I purchased another rental property for $245,000. Again I put down 20% ($49k) and obtained a loan for the remainder. To keep things simple let’s assume I just broke even on a monthly basis (i.e. rent = expenses). This house is now worth about $265,000 which is 8% higher than the purchase price. Not bad but nothing crazy. However if I look at my ROI, I made $20k on a $49k investment which is a 40% return on investment. Again I ask, where can you get a 40% ROI with relatively little risk.

Control More Assets

If you compare ROI of cash real estate purchases vs leveraged purchases we can see the clear winner is leveraged purchases (110% vs 548% and 8% vs 40%). However this is far from the only benefit. By using less of your own money to purchase real estate (0r any asset) you are able to purchase and control much more. Leverage could be the difference between owning no rental properties and owning several. In the two examples above I invested $80,000 (not including closing costs) and acquired two appreciating and income producing assets. Without leverage I wouldn’t have been able to come close to buying either one.

Don’t Over Leverage

Now, although I am clearly a huge proponent of using leverage to acquire rental properties I do not support over leveraging or being reckless with debt. That’s exactly what happened to Dave Ramsey when he was 28 and why I believe he preaches against the use of debt. He is assuming everyone will be as reckless as he was. I on the other hand have more faith in you. If you are even reading this blog then you are most likely financially responsible and looking for ways to accelerate your wealth generation. If you noticed, in both of my examples I put down 20% with my own money. In fact, I have put down 20% for every property I have ever purchased. That provides me with a buffer in case I need to sell the property for unforeseen reasons. In those examples if I put down less of my own money (e.g. 10%) then my return would have been even higher. Just keep in mind that the less money you put down the more risk you are taking on. Ultimately it’s your decision and we all have a different risk tolerance. I just caution you to not go to the extreme. Always consider worst case scenario and how you would handle the worst case if it occurred.

Cash VS Leverage

In both examples above, not only was my ROI dramatically higher due to the use of debt but if I had to pay in cash I never would have been able to purchase either property. I didn’t have $155,000 cash sitting around in my first example and another $245,000 in the second. So if I was following Dave Ramsey’s advice I would still be sitting here with neither property which so far have a combined $190,000 return (not to mention rental income, tax benefits, etc).

In example #1 if I had purchased the property in cash my ROI would have been 110% however my ROI jumped to 548% when I used leverage. Not only that but only investing $31k allowed me to invest in more rental properties than I could have if I paid $155k cash.

In example #2 if I had purchased the property in cash my ROI would have been 8% which jumped to 40% due to the use of leverage.

Some situations don’t allow the use of debt to purchase properties (e.g. if the price is too low or if the house is uninhabitable). However, if the option is available to leverage a bank’s money to purchase a house it is almost always better to do so.